Important Things to Know About QE2 (Forewarned Is Forearmed)

Summary: There have been megabytes of analysis of the Fed’s second quantitative easing program (QE2), most of which overlooks some important points. See the links at the end for more information.

Some important things to know about QE2:

QE2 is a desperate act by the Fed

Expect QE2 to be late, slow, and small

Don’t expect big benefits

Focus on the real threats; ignore fears of hypothetical dangers

The amazing thing about QE2

(1) QE2 is a desperate act by the Fed

They call it unconventional monetary policy. A response to a slowing US (and global) economy after conventional policies have the banks glutted with idle reserves and brought short-term rates to near zero. After three years of economic stress, the debt-laden US economy cannot withstand another decline. And unless we have a crash, there will be no new fiscal stimulus programs to replace the fading American Recovery and Reinvestment Act of 2009 (see Wikipedia).

The US government will do QE2 because it has no other options, except prayer.

(2) Expect QE2 to be late, slow, and small

The Fed telegraphs its actions, allowing investors to adjust — and test for adverse reactions before implementation. An announcement of QE2 was expected after the Fed’s September meeting. They punted it to the November meeting. Perhaps uncertain about the slowdown; perhaps fearful of becoming an issue in the elections (they’re not popular among Republicans, except among Republican bankers).

Some expect bold Fed action at its meeting on November 2-3, probably too late to prevent a second dip (any stimulus will take months to have visible effects). Disappointment is likely. Central banker DNA codes for a cautious nature, preferring reactive and incremental steps. If the economy continues to slow, we can expect one or two trillion dollars of purchases by the Fed (probably all Treasury bonds, but in its later phases they might buy corporate paper or mortgages).

lower the value of the US dollar, improving US competitiveness and boosting exports

lowering long interest rates, stimulating borrowing by households and businesses for consumption and investment

None of these are certain. We might get one of these on a significant scale; we might get none.

Fed policies to boost asset prices has been a Fed staple since Greenspan; that game may be played out

Exports are not sensitive to small changes in the value of one’s currency (income changes have greater effects), but large changes in the value of the dollar could destabilize the global economy

Until demand and jobs revive neither will consumption nor investment, despite the modest rate changes from any likely Fed programs

Then there are the side-effects. Governments have done little to reduce the stress on the global economic machinery, which could snap at any time. Japan remains weak. The internal tension on the European Monetary Union builds, contained only by its people’s inertia and massive lending by the European Central Bank. And at the center lies the core problem: excessive US consumption and Chinese investment (a dysfunctional symbiosis).

(4) Focus on the real threats; ignore fears of hypothetical dangers

Fears — hysteria, even — about inflation and hyperinflation fill the media (print and electronic). It’s typical of societies with broken minds (OODA loops). Fire extinguishers in hand as the flood waters rise. Building dikes as the crops burn. And today, raising alarms about inflation as the Fed implements QE2, desperately seeking to prevent more deflation. Prices indexes are declining in most developed nations. Loan default rates remain high in many nations, threatening cycles of debt deflation (go here for an explanation).

A few charts tell the tale. Massive government aid has stabilized home prices; the unmanipulated commercial market looks less healthy — down 3.3% MoM in August.

(5) The amazing thing about QE2

The amazing thing about QE2 is our complacency about it. A desperate move taken to avoid a perilous economic decline, with few (or no) precedents of success. The rational response would be caution or concern. Fear or panic would be unseemly but warranted.

For More Information

Articles:

“Economic Outlook and the Current Tools of Monetary Policy“, Narayana Kocherlakota (President, Federal Reserve Bank of Minneapolis), 29 September 2010 — “{}Each of these tools has benefits and drawbacks that must be balanced against each other. With QE, I would say that the multiple effects make the calculus even more difficult than usual.”